Venture capitalists are licking their wounds—and their lips

VC funds invest with a longer term investment horizon and returns to their limited partners (LPs) are not possible unless they exit from their investments.  Attractive returns serve as incentives to the LPs to contribute to future funds floated by VC firms.  While India has never seen more than 20 VC exits in a year - in the first three months of 2010 alone, there have been 10 VC exits (against 3 last year) and analysts see at least 50 exits in the next six-nine months reports Mint.  Attractive exits through IPOs would help establish India as an investment destination for VC / PE funds and the trend in both US and India appear similar with many VC / PE firms waiting to exit and the market also supporting IPOs of VC / PE funded companies.  Highlighting the US scenerio, The Economist reports:

In the first quarter of the year there were almost as many IPOs of venture-backed firms as in all of 2009 (see chart). At the end of March another 43 venture-funded businesses had registered with America’s Securities & Exchange Commission to go public. Encouraging stuff, though some fret that any hiccup in equity markets could scupper these plans.

Source:  The Economist

In the US, while the tough fund-raising environment is forcing more and more VC firms to close down their activities, Steven Kaplan of the University of Chicago’s Booth School of Business and Josh Lerner of Harvard Business School in a recent paper entitled “It Ain’t Broke: The Past, Present and Future of Venture Capital”, point out that VC funds raised when capital is scarce have outperformed those put together when VC firms were flush with cash. Looking at the increase in valuation, VC firms with money to invest, worry about how to get into deals while the rest worry about exiting from the investments already made before the markets tank again.

PE Investors push for more favourable fees and terms, and get them

CalPERS persuaded Apollo Global Management, a large PE firm, to scrap $125m in fees over five years reports The Economist.  Highlights from the article:

• CalPERS plans to bargain aggressively with other PE firms (known as “general partners”) to bring down fees and has urged other investors (“limited partners”) to do the same.

• Institutional Limited Partners Association (ILPA), a network of institutional investors in PE, issued a set of best practices that general partners should consider accepting if they want limited partners’ business.

• ILPA calls for greater transparency, more favourable contractual terms and more generous profit-sharing. 

• PE firms have typically charged investors a 2% management fee, which is intended to cover the basic costs of running their business. Limited partners insist that management fees shouldn’t be a source of profit for general partners, and in some cases are demanding to sit down with them to find out what their real costs are. 

Overall, it is an interesting development that is bound to strengthen the hands of the limited partners.  Some of these, like lower management fees etc have started happening in India too.   It would be better if there are some regulatory guidelines, more specially insisting on a decent level of paid-up capital for the general partner (hopefully this would avoid the temptation to make more money out of management fee) and some form a link/correlation between actual expense and management fee.  The intention should be to align the interests of the GP with the LP.  If VC/PE business aims at long term capital appreciation, then the GP should also aim to make long term money (along-with the LP) instead of higher annual management fee which is delinked from actual expenses at the ground level.

Venture Capital, Before High Tech

Highlights from an interesting piece in New York Times.

THE United States military — credited with spawning the Internet — also helped in the genesis of venture capital. So reveals Spencer E. Ante in “Creative Capital” (Harvard Business School Press, $35), a sometimes slow but ultimately satisfying biography of Georges F. Doriot, the transplanted Frenchman who is often called the father of V.C. Doriot, a United States Army reserve officer who rose to brigadier general, was appointed an administrator - entrepreneur on the home front, responsible for equipping, clothing and feeding millions of soldiers overseas. He and his staff, including many of his students from Harvard, funded research into innovative solutions. A lightweight plastic flak jacket (the Doron) saved thousands of lives. And even some failures had their upsides. Grunts found their powdered lemonade “useful as stove cleaner or hair rinse.”

The book’s matter-of-fact storytelling is not always as superb as the story, but as the book advances it gathers poignancy. Doriot had won the hand of his Harvard-assigned research assistant, Edna Blanche Allen, a brainy beauty. Their 48-year marriage was childless; Harvard men were surrogate sons. Edna had a dream house built for the couple on the Massachusetts shore, then died of lymphoma; her ashes were scattered into the ocean. Doriot kept writing her love poems. Nine years later, in 1987, the pipe-smoking general succumbed to lung cancer. His ashes were cast from the same spot into the Atlantic. DORIOT’S charismatic, French-accented lectures at Harvard over 40 years inspired multiple generations of leaders with firsthand stories and pithy sayings — for example, “Someone somewhere is making a product that will make your product obsolete.” His cause, venture, became ubiquitous, even in philanthropy.

“Someone somewhere is making a product that will make your product obsolete.” - Georges F. Doriot

A Letter to Facebook’s Founder

Deal Professor Steven M Davidoff in an open letter to Facebook's founder - Mark Zuckerberg highlights some important rights which Venture Capitalists normally enjoy when they fund companies. Highlights from the letter -

"I read with great interest your recent interview with Kara Swisher at the D6 Conference. I was particularly struck by your answer to Ms. Swisher’s question about whether Facebook, the popular social networking site you created, can be sold by your venture capital co-owners without your approval. Your response: “I don’t think so.” Your answer made me think of something my own professor at London Business School once said to me: “The day you take a venture capital investment is the day you sell your company.” Venture capital firms are not Warren Buffett — they have limited-term funds and compensation mechanisms that encourage them to exit their transactions once a company reaches maturity. So, is it true that your co-owners can sell without you or otherwise push through an initial public offering of Facebook without your approval as chief executive officer? Well, the answer is maybe."

While the founder said "I don't think so", the Professor says "Maybe". Why is it so? Mainly because of the legal covenants which normally accompany every VC investment. One of the important right is the drag along right. Accordingly to Investopedia a drag along right is "a right that enables a majority shareholder to force a minority shareholder to join in the sale of a company. The majority owner doing the dragging must give the minority shareholder the same price, terms, and conditions as any other seller. This is designed to protect the majority shareholder. Because some buyers are only looking to have complete control of a company, drag-along rights help to eliminate minority owners and sell 100% of a company's securities to the buyer." This issue is explained further in Feld Thoughts.

The Indian Context

In the Indian context, I don't know whether these are practically possible. May be amongst hundreds of transactions, a few might have actually happened when the founder(s) also are inclined to sell out. In a country where the promoters vision starts and ends with their family, and with lax compliance/enforcement environment (notwithstanding the numerous Acts which have been passed regularly by the Central & State legislatures) and a genuine fear that its better to avoid going to Courts for enforcing rights - the current thinking is that it may take around 15 - 20 years (assuming it goes all the way upto Supreme Court) to get justice and even if something positive comes, will there be anything left to implement / salvage .... All these factors inhibit legal recourse and push people towards an amicable out-of-court settlement.

Interestingly, while everyone talks about the multi-baggers that they have had in their portfolio, hardly anyone actually shares information on investments which went sour. There is also a prevailing wisdom that losers come first and its better to concentrate on winners rather than losers. Thus, even in cases involving losers, though the agreement may provide for various rights, still the VCs might prefer not to exercise them, and would rather try to limit the loss/damage and try to get as much as possible and as quickly as possible. In that event, if the founder(s) are not so honest people, they can make use of this general thinking and try to limit the exit proceeds as low as possible, but not so low that the VC would think it is better to go to court to enforce the agreement.

It might be possible and more effective to enforce the rights enshrined in the agreement where there is a separation of ownership and management. In the Indian context, that (generally speaking) does not appear to be the case, thus frightening potential buyers (mainly due to poor corporate governance standards, especially in smaller firms where the distinction between the owner and the company is often blurred). To that extent, though Indian VCs too have same / similar rights, I doubt how many of these rights are actually exercised and enforced.